Crediting Structure All products use an Annual Reset Structure. American Equity and Conseco average the monthly values to determine the annual end point. North American averages 6th and 12th month index values. Southland averages the last six months of the years. Americo deducts a yield spread.

Premium Load 
American Equity - 6.0% in all years
American General Accumulator & Provider - 5.5% in all years 
American General Survivor 500 - 7.5% in all years
Americo - 65% of up to target premium for first policy year only.
AmerUS Foundation Builder - 3.0% in all years
AmerUS Generation Bridge - 0%
Conseco Life - 50% of up to target premium for first policy year, then 2%.
Lafayette - 5.0% up to base premium, 2% on excess
LSW - 1.5% in all years
Lincoln Benefit - 2.0% in all years
Southland - 2.0% in all years
Transamerica Occidental - 5.5% in all years
Union Central - 6.5% years 1-104.5% years 11+

Guaranteed Interest Rate
American Equity - 2.50% 
American General - 2.50%
Americo - 2.00% 
AmerUS - 3.00%
Conseco - 3.00% 
Lafayette - 2.50%
LSW - 2.00%  
Lincoln Benefit - 2.00%
Southland - 3.00%
Transamerica Occidental - 2.50% 
Union Central - 2.00%

Minimum Face Benefit 
American Equity - $ 5,000 Single Premium
American General Platinum Accumulator - $ 25,000, Platinum Provider - $100,000, Platinum Survivor - $250,000
Americo - $ 25,000
AmerUS Foundation Builder - $ 25,000, Generation Bridge - $ 10,000 Single Premium
Conseco - $ 25,000
Lafayette - $100,000
LSW - $ 25,000 (banded amounts)
Lincoln Benefit - $ 10,000 Single Premium
Southland - $ 50,000
Transamerica Occidental - $50,000 (banded amounts)
Union Central - $100,000 (banded-$250,000)

Surrender Charge
American Equity - 15 Years
American General - 19 Years
Americo - Determined by issue age
AmerUS - 15 Years
Conseco - 9 Years
Lafayette - 15 Years
LSW - 15 Years
Lincoln Benefit - 12 Years
Southland - 16 Years
Transamerica Occidental - 20 Years
Union Central - 15 Years

Forecast: Rising Participation Rates    8/99        Return to Library Index
In the last two months the number of carriers raising participation rates outnumbered ones cutting rates by a ratio of 8 to 1.  In our November, 1998 issue we said rates would increase modestly in 1999. The rationale behind our forecast was that option prices would fall as volatility levels declined. By the end of June the VIX Index was at 19.80 - the lowest volatility level observed since last Christmas. Lower volatility has resulted in lower option prices. However, the main reason for today's higher rates is higher bond yields.

A lower return earned on the bonds means more money needs to be invested in the bonds to provide the minimum guarantee. This leaves less money to buy options. A higher return means less money is needed to produce the minimum guarantee because the bonds increase in value faster. This leaves more money to buy options.

Nine months ago the yield on the thirty year Treasury bond was 4.84%. At the end of June the thirty year Treasury bond was yielding 6.00%. What effect do rising yields have on index annuities?

Say that your minimum guarantee is a return of $1.10 at the end of seven years for each $1 of premium. If you could only earn 4.84% you’d need to invest 79 cents today to provide the $1.10. However, if you could earn 6% you’d only need to invest 73 cents to provide the $1.10. A higher interest rate environment means you have 6 cents more to invest in options.

So, we were correct that option prices would decline, but the real impetus behind increasing participation rates was higher yields enabling carriers to set aside fewer dollars in bonds and leaving more dollars to buy options. This climate should persist for the next few months permitting participation rates to modestly increase.

Index Annuity Performance 6/98-6/99    8/99        Return to Library Index
On July 17, 1998 the S&P 500 rose to a value of 1186.75 - a 22.3% increase since the first of the year. Six weeks later the index closed at 957.28 erasing those gains. The index gained 26.7% for calendar year 1998, but if you had purchased the index at its July high you were only up 3.6%.

During the first few months of this year the index seesawed between 1200 and 1300. If you look at the one year period ending 6/30/99 the S&P 500 was up 21.07%. However, due to the wild gyrations of the market index crediting methods reported an extreme range of returns.

We examined returns of three different index structures using the average participation rate in effect in June, 1998 and compared their performance with different categories. The average participation rate for a term end point annuity a year ago was 75%. The average participation rate for a point-to-point annual reset structure was 70% with a 12% cap on interest. The average participation rate for an annual reset using monthly averaging of index values was 80%. Performance for the one year period was as follows:

Term End Point EIA
The term end point structure produced a higher gain than over half of the stock mutual funds on the market. Even though the mutual fund returns includes reinvested dividends the average mutual fund effectively "participated" in 65% of the S&P 500 performance for the year. Index annuities are not designed to be a replacement for mutual funds. 

Although a term end point annuity’s gain is not locked in until the end of the period you need to look at the magnitude of the gain. If the index one year from now has retreated to where it stood in early Spring of this year the gain of the term end point structure is still higher than the CD gain over the two years. If the index only increases 8% over the next twelve months the annuity’s total gain is the equivalent of earning four years worth of CD interest in only two years.

Annual Reset EIAs
The typical annual reset structure basing crediting on absolute index movements credited 12% - more than double the return of certificates of deposit. The typical index annuity using monthly averaging of index values credited 4.67%.

The Effects of Averaging
For the twelve month period ending 6/30/99 the S&P 500 rose 21.07% from beginning to end. However, if you average the end of the month values of the index the index rose 5.84%; if you average the daily values the index rose 5.61%. Why the large disparity?

Averaging always drives values to the middle. This means when index values are rising averaging will produce a smaller value than the absolute end point. When values are falling averaging results in a higher value than the absolute end point. If you look at the last thirty years when the S&P 500 recorded a gain, monthly or daily averaging produces an effective “participation rate” equal to roughly 60% of the absolute index gain. But, for the year ending in June averaging produced an effective participation rate of 27%. Why?

This annual period includes the 20% market correction that happened last August and lasted into the Fall. The index did not return to its beginning level until November. This means that a third of the values used in averaging were lower than the starting point. Compounding this disparity between averaging and absolute returns was that half of the annual gain resulted from upward movements in only two months - December and June, and an absolute crediting method realized the full effect of the June increase.

Rising Rates
The cloud of last year’s correction is almost erased and the stock market appears to be coping with a higher interest rate environment. Participation rates should modestly increase, at least over the short term.

Will interest rates continue to rise? Economists are divided in their outlook. If interest rates rise the stock market could feel the effects and back-to-back years of double digit gains could be behind us, but index annuities will increase their participation rates to capture a larger portion of any gain. If this is the peak in interest rates the stock market should react favorably in the future and today’s participation rates will be looked back on with fondness.

Leverage Effect Of Options     8/99        Return to Library Index
When the mechanics of an index annuity are explained the companies often use the allocation of a dollar of premium. Using a point-to-point structure as an example, they’ll say that 10 cents or so out of the dollar is used to cover commissions, pay overhead and generate the insurance company’s profit; 72 cents goes to bonds or similar instruments to provide the minimum guarantee return; and the remaining 18 cents buys options to provide the potential for excess interest.

If at the end of the term the index is down the option would expire worthless, but the bonds would provide the minimum guaranteed return. If the index is up the company will exercise their option and credit a gain. Most people can understand how the bonds protect the minimum guarantee, but the option side of the equation is not fully understood.

If the 18 cents from our dollar buys a “full” option (for every 1% increase in the index the $1 of premium increases 1% in value) the annuity could offer a 100% participation rate. If “full” options cost 9 cents the company could buy two of them and you’d have an effective participation rate of 200%. If “full” options cost 36 cents we’d only be able to buy half of one, so we’d have a participation rate of 50%.

We’ll say that a “full” option costs 18 cents. This means that if the index doubled by the end of the term our $1 of premium would be worth $2. It also means that the 18 cents we spent on the option is now worth $1. How can the option increase five times in value when the index only doubled? The answer is the multiplier or leverage effect of options. To keep this simple, we’ll use an example of buying a call option on a stock and ignore trading costs.

Say that XYZ stock is selling for $50 a share. You could purchase 100 shares of XYZ stock for $5,000. Six months from now you sell the stock. If the price is $55 a share you’d receive $5,500 - $500 more than you paid, you’d have a 10% profit. However, if the stock is worth less than $50 a share you’d take a loss.

When you buy an option you have the right to buy the stock at a given price within a set period of time. The owner of the stock will sell you this right and charge you a fee. Instead of buying XYZ stock we buy an option from the seller that gives us the right to buy 100 shares of the stock for $50 a share at anytime within the next six months. For this right we pay the seller $250.

At the end of six months the price of the stock is $55 - a 10% increase in value, but we have earned a 100% return on our money. How can this be?

Our option gives us the right to buy the stock at $50 a share even though it’s now worth $55 a share. We would simultaneously exercise our option to buy the 100 shares of stock for $5,000 and sell them for $5,500, netting us $500. So, we’ve earned $500 on our $250 investment.

This is how options work. If XYZ stock is worth less than $50 a share at the end of the period, we’d simply let the option expire. We’d be out the $250 we spent on the option, but that is the limit to our risk.

Why would the seller sell us the option? If the stock goes up the seller misses out on the gains! True, but maybe the seller feels that the stock is not going to go up. And, even if the option is exercised down the road in the meantime the seller continues to receive any dividends the stock might pay and we’ve paid the seller $250 for the option.

Index options are a bit more complicated because there aren’t specific stocks backing the option, but the basic concepts are the same. Options provide a leverage or multiplier effect when values rise.

The price of options is driven by many factors. The dividends earned on the underlying stock(s) contribute to the seller’s return and a low dividend yield may prompt the seller to ask for a higher price. Time is a consideration - the longer the buyer has to exercise the option the more the seller will charge for the right. And, volatility and market expectations are a large part of an option’s price - if the seller feels that values are heading higher they’ll want more money.

Index annuities work because the purchase of options by the company provides a leverage effect that can produce competitive returns. Because buying options gives you rights and not obligations, the company’s exposure is limited if the market declines.

Take Some Money Off The Table    9/99        Return to Library Index
The stock market has enjoyed an incredible run. The S&P 500, without reinvested dividends, has tripled in the last five years. Several mutual funds have accomplished this in an even shorter period. I'm optimistic about the long term outlook for the market. However, I also realize that the market goes down from time to time.

One of the definitions of a bear market is a decline of 20% or more. This means if a portfolio is worth $300,000 today it would be worth at best $240,000 in the midst of a bear market attack. How long will it take to recover the loss? Well, if you look at five year holding periods of the S&P 500 over the last 30 years you find that roughly 20% of the time the index was lower at the end of five years than when it started. While the market always did recover, you were in a bit of a fix if you needed that money during the down years.

  One solution is to shift part of today's profits into a vehicle that doesn't subject the principal to market risk. Index annuities offer this protection and provide at least a minimum guaranteed return if the market slides, with the potential for higher returns than other conservative instruments when the market rises. Index annuity portfolio hedging is a strategy that aids in protecting your gains while keeping you in the game.

Index Annuity Carrier Web Sites    9/99        Return to Library Index
We examined the Internet web sites of carriers offering equity index annuity and life products. The scope of the study was limited. From a consumer viewpoint we approached each site and tried to determine if the carrier offered index products and if so, how we could obtain more information. We then examined the sites from an agent’s perspective.

We searched each web site for the basic information that an agent would need and looked for current interest rates, product specifications and which states the products were approved in. We then examined whether an agent could obtain account information on existing customers, download customer illustrations or illustration software, and use the site to print applications or policy service forms.

Of the 33 carriers that we researched, 29 had web sites. Four carriers, American Investors, GPM Life, Life Insurance Company of the Southwest and USG/Equitable of Iowa did not have sites. Twenty of the sites required an agent password to obtain further information. The majority of these carriers provided us with a password for research purposes or sent us data on the information within the protected portion of the site. The percentage of web sites that offer the following information are:

Percentage of Carriers Offering Services
Ability to Print Forms 45%
Product Specifications 41%
Current Interest Rates 38%
Customer Policy Data 34%
State Approvals 28%
Electronic Applications 7%

A Work In Process
To be blunt, most of the web sites aren’t worth the time it would take an agent or a consumer to access them. The majority of the information available to a consumer is so generic that it would not prompt them to go any further. Two notable exceptions are the Northern Life and Transamerica Occidental sites which have excellent sections that helps the consumer estimate their insurance and retirement needs that leads to the consumer requesting an appointment with an agent.

The majority of agent sites also suffer from being too generic or fail to provide relevant information. A few of the sites are a true electronic resource providing immediate answers to common questions and aiding an agent in producing business. Two carriers, Integrity Life and General Life, allow agents to submit applications electronically on some products.

The web sites are a work in process. Most of the carriers are expanding or modifying their sites to enhance available services. It appears that carriers need to decide the mission of their web pages. Is the site designed to generate consumer leads...reduce phone calls to the home office...or be an entirely new way to conduct business.

    Return to Library Index

Though The Road Is Rocky, EIAs Producing Excellent Overall Returns    10/99
At the conclusion of September the stock market was off about 10% from its record high, ending a very volatile twelve month period.  The peaks and valleys caused a wide variation in index annuity returns depending upon the day you purchased the annuity and the crediting method used. On any given day the difference between the returns produced by a point-to-point method and an averaged method could be dramatic. However, if you look at the Mean returns generated by contract years ending over the entire period by all of the different annuity products you find the typical index annuity - whether point-to-point or averaged - produced an annual return of 11%.

I found this so interesting I went back and looked at the average monthly returns over the last two and a half years for different crediting structures. I used the participation rates in effect at time of purchase and examined the returns of all annual reset annuities calculating the "best" and "worse" returns each month.

The following chart shows differences between returns for specific periods. The Mean returns for all crediting structures ranged between 10% and 13%. In other words, when you look at the entire period, even if you had consistently picked the worst performing index annuity, your return was only 3% less a year than if you picked the top performing index annuities.

Why would returns be so similar overall? Most carriers buy options to realize the excess interest potential of the annuity. While the money the carrier has available to spend on options is impacted by the cash needed to produce the minimum guaranteed return, and carrier profit and agent commission concerns, the significant factor is the cost of the options.

There are three common methods used to limit the cost of the options. The first is to simply lower the degree in which the annuity participates in any gains. The second method is to permit the annuity to participate in more of the increase, but limit the total gain that may be earned. The third method is to use an average of index movements which has the effect of diluting returns in raising markets.

How does all of this relate to an index annuity’s return? If you don’t use averaging in an index formula you will either have a lower participation rate or need to use a cap to limit gains. Caps and averaging reduce the cost of the option strategy and permit you to have a higher participation rate. But, the bottom line is regardless of the crediting methodology used everyone is basically buying options in the same market.

So, if you look at the last twelve months annual reset index annuities credited an average return of around 11%. If you examine the last two and a half years the annuities credited an average return of 10% to 13%. Even though the overall returns for the different crediting methods are similar, some methods require more explanation to avoid unrealistic client expectations. Here’s what I mean.

For a contract year ending on August 31, 1998 unaveraged index annuities credited 4% to 5%. Although the annuity owners may not have been happy with these returns they probably understood why the returns were down because the media was telling them that the market was down.

By contrast, for a year ending March 31, 1999 the S&P 500 was up 16.76%; averaged index annuities credited 2% to 3% for the period. The reason for these statistically abnormal returns was an extremely volatile market period. The returns were an historical exception to the norm and over a longer window of time averaged structures produced the same or higher returns than unaveraged structures. But, unless the client had been prepared for the way that averaging affects returns, they might have been upset.

While averaging products may require a little more education on the way they work, all index annuities are writing a track record that shows they can compete successfully against other savings vehicles, regardless of the crediting methodology used.

Are index annuity returns acceptable? If you consider that an index annuity is a conservative savings vehicle that grows without subjecting the principal to market risk, and compare the returns to other conservative instruments, these double digit returns compare very favorably.

Client Needs & EIAs    10/99        Return to Library Index
Index annuities can provide solutions for specific financial concerns.

Scared Savers
They’re an ideal bridge for a customer that has never invested in the stock market because of the fear of loss, but wants the potential for a higher return than they’re earning on other saving instruments.

Nervous Investors
Index annuities are also attractive for stock market investors that want to take their profits, don’t want to lose principal, but want the potential for a higher return than they might get from a money market account.

Although the excess interest in an index annuity is linked to the performance of an equity index, index annuities are not equity investments or mutual funds. Mutual fund returns include reinvested dividends and subject the principal to market risk. Index annuities do not include reinvested dividends, but the principal is protected from market risk.

Early Retirement
Say that an individual has taken early retirement and has a lump sum pension plan distribution. The person will start drawing on these funds to provide income in a few years. The money could be invested in mutual funds. Over time, equity investments have produced high returns, but the stock market is fickle in the short term and could go down. An index annuity guards against risk to principal if the market goes down while providing higher upside potential than certificates of deposit.

For The Children
A retired couple already owns traditional fixed annuities and are planning to leave the money in the annuities to their children. An index annuity assures them of earning at least a minimum return while giving them the possibility of bequeathing an even greater legacy.

For A Secure Retirement
Many people invest their retirement funds in fixed rate instruments. This may be prudent for a worker in their fifties, but it’s a costly strategy for a thirty year old. An index annuity gives these workers guarantees and higher potential growth.

No-Load Investor
Index annuities do not usually reflect an initial sales load or management fees. They may be attractive to the no-load investor.

Pension Plans
SEP, 401(k) and 403(b) plans are excellent retirement savings vehicles. However, even if a person’s contributing the maximum to the plan they can still have inadequate funds at retirement if they invest too conservatively. For the risk averse individual an equity index annuity can provide the potential for a higher return than fixed rate instruments with the principal protection that lets them sleep at night. Equity index annuities are an excellent vehicle for retirement saving.

Short Investment Horizon
Over the long term the market has rewarded investors that stay the course, but it can be fickle in the short run. Index annuities offer the potential for higher returns than other short term vehicles without market risk to principal.

Jumping Off The Wheel
I’m a wee cynical about surveys reporting that investors will stay invested in the market even during a long bear decline...they’ve always jumped ship before. An index annuity may keep investors in the market - instead of selling out at the bottom, because they know their principal is protected from market risk and any leap may result in a surrender charge.

An Alternative To Split Investing
The Split-Investing concept means placing part of the original principal in bonds or other fixed rate instruments with the balance invested in a higher risk vehicle. The idea is that at the end of the period the fixed rate investment will be equal to the original principal even if the higher risk vehicle tubes. An index annuity gives you the potential for higher returns than a fixed rate instrument and still offers a minimum guaranteed return if the market slides.

Robbing Banks
The Consumer Federation of America reports that $1.5 trillion are in bank accounts paying 2% interest or less. Do you have an alternative for these people?

Personal Service Still Builds Success    11/99        Return to Library Index
I've been reading articles recently expressing concern about the future role of agents when all of the regulatory walls are toppled. Most of the concern seems to be directed towards the effect banks will have on the marketplace. Although it may be argued that banks should stick with banking, the rest of the financial services industry has been treading on their toes for years.

Stockbrokers have been able to sell CDs for almost two decades, my insurance agent offered the best loan rate on the car I purchased last month, and both my credit card and brokerage companies enable me to use ATMs in different cities and write checks on my accounts. In a generation you may be telling your grandchildren "See that building on the corner, the one that's now the Michael Jordan Home for Indigent Trust Officers, it used to be a bank." To which your grandchildren will respond "What's a bank?"

Today, most banks may offer investment and insurance products. The only true barrier left is the underwriting side of the business. There will be consolidation. However, even in a world of consolidation and e-commerce the independent agent will survive.

Building a successful relationship with most clients doesn’t require an agent or broker to be the lowest cost provider. There will always be individuals that use cost as the main criteria for their financial decisions, but these people were never clients they are shoppers. Brokers should leave these low margin market units to the competition.

The Internet enables individuals to obtain almost unlimited data on investments and insurance. Some criers are proclaiming that this information portal spells the end of the agent. However, before there was the Internet these were the same consumers that spent days at the library reading Value Line or Morningstar.

There will always be people that want to do things on their own...that’s why hospitals have emergency rooms.

The vast majority of individuals want personal assistance and attention in their financial lives. Independent agents and planners can provide a level of client intimacy that others may find difficult to emulate. A personal agent, planner or broker knows a client’s likes and dislikes.

The definition of what an agent, broker or planner does will change. Many agents and brokers can already offer mortgages and money market accounts, in the very near future their service menu could include trust services and business checking. The successful agent will do more than simply sell product; they will function as a financial valet.

The stock market and medical science are creating wealthy retirees that live twenty or thirty years past retirement. They have more money than their parents ever did and they remain active much longer. They need traditional investment advice, estate and medical protection, but they also need someone to help them with day to day financial details.

Tomorrow’s agent will still offer traditional insurance coverage, but in addition they will find the most favorable CD rates for their client’s money, pay the client’s real estate taxes from their managed account and ensure that the client’s accountant has this year’s income tax files.

Don’t be worried about banks. The key to agent success in the future is the same as it is today. Provide excellent personal service to your clients.

Index Annuities Instead Of Bonds    11/99        Return to Library Index
It's an investing tenet that stocks and bonds belong in a portfolio. The reasoning behind this is that bond returns will tend to go up or remain stable when stock prices fall. Bonds and bond funds are regarded as more conservative than equity investments and are presented to consumers as the lower risk element in an asset allocation model.

This was a wretched year for bonds. This performance should not be viewed as in any way representative of how bond mutual funds will perform over time, but this period does highlight the possible market risk to principal of bond investments.

The average total return of these bond funds was 2.57%; performance ranged from a high of 11.9% to a loss of 5.35% for the year. If a consumer bought the bond fund as the lower risk element in the portfolio how are they reacting to a loss?

My research indicates that investors may earn similar or higher average returns by using index annuities instead of bonds and that the annuities do a better job of protecting the client against loss of principal than a combination of equity and bond instruments. The premise is that a vehicle that bases returns on an equity index while protecting the principal from market risk could provide a comparable return with lower volatility.

Let’s look at the last five years. The average total return of these bond funds was 46.96%. Index annuities weren’t around five years ago. However, almost every index annuity bases performance on movements of the S&P 500. Over this five year period the S&P 500 increased 177.23%. If a point-to-point index annuity had offered a 27% participation rate it would have outperformed the average largest taxable bond mutual fund.

The last five years have been exceptional for the stock market, but with the exception of the last year its also been a pretty good time to own bonds because we’ve seen a declining interest rate environment. Let’s compare the annual returns of the largest taxable bond funds with the S&P 500 from 1988 to 1998.

The bond funds produced higher returns than the S&P 500 in three periods, but if you look at the entire period the S&P 500 had an average annual return of 16.49% while the average bond fund reported an annual return of 9.53%. A point-to-point index annuity with only a 50% participation rate would have matched the average bond fund’s return. An index annuity with an annual reset structure and an effective 56% participation rate would have beat the average bond fund, and in years when the bond fund’s performance was negative the index annuity would have protected the consumer from loss.

It’s certainly true that stock and bond values do not move in tandem. When we compared the annual returns of corporate bonds with the S&P 500 over the last thirty years we found that there was a correlation of .52. Correlation is a term that implies a relationship between two variables. If two investments mirror each other’s performance they would have a correlation value of 1.0. If the investments always reacted directly opposite the other they would have a correlation value of 0. A value of .52 means that the stock market and the bond market don’t always move in the same direction or with the same magnitude, and the previous examples illustrate this.

If you look at annual returns for the last quarter century the S&P 500 index, without reinvested dividends, produced an average return of 12.82%; the Lipper Corporate Bond index averaged 9.78%, but the S&P 500 was more volatile. If you had invested only in the S&P 500 you would have incurred losses in four years of up to 11.5%. Instead, let’s place 75% of our cash in the stock index and 25% in the bond index.

Adding the bond index drops our overall average return to 12.06% - our combined return is now 94% of what the stock index alone generated. However, our volatility as measured by the standard deviation is now 83% of what it once was. In other words, even though our return dropped a little bit our risk of getting a bad return dropped significantly.

This is the reason for adding bond investments to a portfolio. Since bonds do not move exactly like stocks, and tend to be less volatile, the addition of bonds helps to smooth returns. But, let’s look at using equity index annuities instead of bonds.

If we do the same calculation and substitute an index annuity which would have participated in 70% of the stock index movement we get a 12.08% average return with similar volatility. So, with 75% of our principal invested in the stock fund and 25% placed in the index annuity the stock/annuity return would have topped the stock/bond return as long as the annuity participated in at least 70% of the index movement.

What if we eliminated the combinations and simply placed all of the money in an index annuity? If the index annuity had participated in 86% of the index movement the average return would have been 12.12% - about the same as the stock/bond combo, but our risk of getting a bad return is now 74% of what it once was. The index annuity strategy produced a similar return and unlike the bond or stock instruments protected the principal from market losses.

Now, participating in 70% and 86% of index movements may seem high today, but participation rates are to a large extent driven by the interest rate environment and option prices. Today, long term interest rates are around 6%. The ‘70s and ‘80s were a time of double digit rates. Higher yields translate into needing less money out of the premium dollar to provide the minimum guarantee, so more money is available to buy options.

Although option prices were up and down through the period, the overall effect was that index annuities could have offered participation rates well in excess of one hundred percent. Hypothetically, index annuities would have produced comparable or higher returns than bond investments in the past quarter century. How will they compare in the next decade?

The answer depends upon your beliefs in future stock market performance and the direction of interest rates. I believe that the next decade will be a period of low inflation with bond interest rates tracking closer to their historic averages...between 3% and 6%.

Although no one can predict the future, even modest stock market growth could result in index annuities generating higher returns than bond investments while protecting the principal from market risk.

Not Index Annuities    12/99        Return to Library Index
I've been attempting to review flexible premium annuity policies that base the crediting of interest on the performance of "segmented asset classes within a carrier's general account". These general account segmentations are supposed to act like different bond allocation strategies. However, it's difficult to determine the exact nature of the segmented assets that will be used for the various strategies during the life of the annuity.

The ones I've reviewed are not index annuities. The ultimate return that the consumer receives is determined by the insurance company, subject to minimum contractual interest guarantees.

Indexed CD’s Haven’t Caught Fire    12/99        Return to Library Index
A few banks have been offering certificates of deposit that base final interest credited on the movements of an external index while guaranteeing a 100% return of principal when held to maturity. First Union may well be the sales leader with their Market Power CD series, but other financial players like Bank One and even Charles Schwab & Company are either offering or planning to offer indexed CDs. However, sales to date have been less than exciting.

The typical structure combines a zero coupon certificate of deposit with the purchase of an option on an index. Index CDs have been offered with maturities of three to twelve years. The same basic theory applicable to index annuities is at work with indexed CDs - if the market goes up the option increases in value and the index CD buyer (like the index annuity buyer) benefits, if the market goes down the insurer’s bonds or bank’s zero coupon CD protects the buyer from market risk to principal.

The stated benefit of an index CD is upside potential and FDIC insurance. The index CDs I have studied work like a point-to-point index structure with the CD index owner participating in a portion of any increase.

However, there’s a significant flaw that will keep these products from becoming a major player in the savings universe. The zero coupon CD portion of the index CD generates phantom taxable income. In other words, even though you won’t be receiving annual cash from your index CD, you’ll be getting a Form 1099 every January taxing you on the interest build up. How much could it be? Well, on a $10,000 deposit in a ten year index CD the buyer could wind up paying taxes on over $5,000 even though you’re not taking any money out!

Now, index annuities are not a magical tax avoidance device. When you withdraw money from an annuity you pay taxes on the growth...annuities are tax-deferred not tax-free. But, when you have to pay the taxes on the annuity at least you have the money in hand and you’ve been able to watch the money grow without current taxation.

This phantom tax will keep index CD sales low because people don’t like the idea of paying taxes when they’re not getting the money. The idea of packaging a higher risk investment with a principal protection component is not new. In the ‘80s Kemper marketed the "Double Play Trust" which combined zero coupon bonds with a growth vehicle, and there have been several attempts by others to promote similar concepts, but they’ve fizzled.

The only way around the problem is to target the index CD in retirement accounts where this taxation isn’t an issue. However, if taxes aren’t a problem a customer could buy their own zero coupon CDs. There are a couple of other aspects that don’t help the competitiveness of the product. The index CD’s I’ve looked at have surrender charges and a market value adjustment feature. While these features are common in the annuity world they’re something new for the bank customer to consider. In addition, the fine print in the index CD may state that if economic circumstances dictate withdrawals may be prohibited until maturity. So, although the customer’s index CD is FDIC insured they could get back less than they started with if they have to take an early withdrawal, or could be forced to wait five, eight or ten years before they could gain access to their money. 

A final thought is that we don’t know how competitive index CD rates will be when compared with index annuity participation rates. FDIC won’t be much of an incentive if the insurance company’s offering an 80% rate and the bank is offering 35%.

We’ll be hearing some noise from the personal finance media about index CDs and you’ll be getting questions on how they compare to index annuities. The answer today is that they really don’t compete. Index Annuities offer complete tax-deferral, the majority offer some free withdrawal feature, participation rates are very competitive and although you may be hit with a surrender charge you can get your money out of an index annuity.